The European Central Bank has always been a special case in the world of central banks.

While policy is decided centrally, actual enforcement and implementation of that policy is conducted on a national central bank (NCB) level.

That means every NCB is in charge of providing liquidity to its own particular market. The Irish NCB’s routine distribution of emergency liquidity assistance (ELAs) on a near enough unilateral basis (there’s only the need to notify central command in Frankfurt) is a good example of how the system works.

All payment surpluses and deficits created as a result of these unilateral NCB processes are then balanced out via the so-called Target2 system (Trans-European Automated Real-time Gross settlement Express Transfer system).

Generally speaking, the system ensures that all NCBs carrying surpluses channel them over to NCBs carrying deficits.

The problem is that since the crisis unfolded, the number of NCBs handling deficits has started to outnumber the number of NCBs holding surpluses. One particular NCB — the Bundesbank — has become the key provider of funds to the whole eurosystem.

Aaron Tornell, economics professor at UCLA and Frank Westermann, Professor of International Economic Policy at the Institute of Empirical Economic Research, University Osnabrueck flag this point up in a Voxeu.org article on Tuesday.

As they explain:

In the wake of the 2008 crisis, some national central banks, especially those in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS), have dramatically increased their loans to financial institutions. To fund these loans, GIIPS central banks borrowed mainly – via the ECB – from other central banks, in particular the Bundesbank.

In order to fund these loans, the Bundesbank sold its holdings of German assets. As shown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion.

In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action. Hence, it appears as if the Eurozone crisis is entering a second phase in which policymakers feel the need for new measures to prevent market turmoil.

In other words, the Target2 system is indirectly propelling the German Bundesbank to sell off all its assets to finance the lending of other Eurozone central banks. So much so, it hardly owns any assets of its own all anymore.

Note the following chart:

It’s an interesting turn of events, not least because market forces are directing the Bundesbank to release as many government assets back into the system as possible (just when they are needed most), in order to transfer the funds over to deficit running NCBs.

But, as the authors ask, what happens when the Bundesbank runs out of assets to sell?

At risk, after all, is not only an inability to raise money for fellow NCBs, but also the ECB’s firepower in the collateral markets. Via that, arguably, its ability to dictate monetary policy.

As the authors note:

As we can see in Figure 2, the drastic decline in securities held by the Bundesbank tracks closely the sharp increase in loans from the Bundesbank to the Eurosystem: the securities of the Bundesbank declined from €268 billion in December 2007 to €21 billion in October 2011. Meanwhile, the loans to the Eurosystem increased by nearly €400 billion. The latter number is larger because the Bundesbank also borrowed in the private capital market – by taking deposits – as shown in Figure 3 further below.

Already compromising the Bundesbank is the fact that its stock of bonds reached zero long before the 2008 crisis even broke out. The only firepower the Bundesbank had left was its stock of loans to the private sector, say the authors.

But even this is fast approaching zero. At the end of October 2011, loans outstanding stood at a meagre €21bn. In 2008 they equaled €277bn.

So what could it do next to raise funding instead? There are two obvious choices, say the authors: sell gold (€132 bn worth) or sell off the Bundesbank’s internationalal reserves (some €49.5bn) . Unfortunately, neither are likely to be palatable to the general German public.

This leaves only one workable alternative for now: Drawing deposits from the system and distributing them over to the deficit running NCBs. Luckily for the Bundesbank, a lack of investable safe collateral has seen a major rise of deposits in its system. There’s plenty to go round for now. But, that said, it’s hardly a full-proof plan, since it leaves the Bundesbank not only exposed on a liability front, but running a vulnerable borrowing-short, lending-long position.

Here’s some more from the authors on how the mechanisms actually work (our emphasis):

As we have described, in the European monetary union, the stock of securities held by a central bank can increase in a member country even though the ECB might not pursue an expansionary policy for the Eurozone as a whole. This creation of base money is not done via the printing press as in old times, but electronically. To illustrate the mechanism consider the following example. An owner of Greek government bonds uses them as collateral to borrow from his commercial bank, which in turn borrows from the Bank of Greece.

The Greek central bank wires the funds via the ECB to the Bundesbank, which in turn deposits them in the Frankfurt bank account of the Greek resident. As a consequence, the Bundesbank gets a ‘TARGET claim’ on the ECB and the Bank of Greece gets a ‘TARGET liability’ at the ECB. This TARGET claim is secured by collateral – the Greek government bonds – deposited at the ECB that were previously in the possession of the Greek resident.

Through this operation, the increase in the stock of securities at the Bank of Greece is matched by a reduction of securities in the Bundesbanks’ balance sheet. The Bundesbank sells some of its assets to be able to deposit the funds into the Greek residents’ private Frankfurt bank account. As a result, German assets are replaced by ECB collateral (TARGET claims) in the balance sheet of the Bundesbank. The aggregate Eurozone monetary base, however, is unaffected in this example (see Garber 1998, Sinn and Wollmershäuser 2011, and Buiter et al 2011). Figure 4 shows the dramatic increase in loans from the German Bundesbank and the Dutch central bank to the Eurosystem.

From 2007 to September 2011, the TARGET liabilities of the GIIPS at the ECB have increased by €329 billion, while the TARGET claims of Germany at the ECB have increased by €404 billion and those of the Netherlands by €75 billion. These numbers are extraordinarily large. The TARGET liabilities of the GIIPS amount to 63% of total stock of securities held by central banks in these countries. A comparison of Figures 2, 3, and 4 reveals that over the period from 2007 to the third quarter of 2011 the increase of the Bundesbank’s TARGET claims at the ECB tracks its reduction in loans to the private sector plus the increase in deposits it takes from credit institutions.

So while the ECB systems’ central banks now hold plenty of periphery debt and other rubbishlow-quality assets, they hold hardly any quality collateral at all. Indeed, due to the Target2 system, you could say that most of the good stuff has ended up in a handful of private hands instead.

How long can this collateral laundering operation go on?

In theory for as long as periphery banks have access to ECB acceptable collateral. Though, not even that would necessarily stop the borrowing, suggest the authors:

Should central banks run out of government bonds, the national governments could issue more bonds, and sell them to private banks. Banks in turn could use them as collateral to borrow from their central banks. Thus, practically, there is no limit to the amount of domestic government bonds the national central banks could use as collateral to accumulate TARGET claims at the ECB.

————Up to now, Bundesbank loans have allowed GIIPS central banks to buy government bonds without a corresponding increase in the monetary base of the Eurozone as a whole – ie, without the ECB printing more money (after an expansion in 2008, the monetary base returned to trend growth). Before long, however, the Bundesbank’s stock of domestic assets is going to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets.

At that point, the Bundesbank will not be able to lend more funds to the Eurozone TARGET mechanism. As a result we are heading towards the multiple equilibria zone in which beliefs of a breakdown of the Eurozone are self-fulfilling.

And here’s their critical point:

In such a situation, market participants may transfer funds from financial institutions in fiscally weak countries to other ‘safe’ countries like Germany. In tranquil times, such transfers can be done seamlessly through the TARGET mechanism of the ECB. However, if a critical mass of agents were to engage in such capital flight away from fiscally weak countries, the TARGET system would be overwhelmed. In principle, a speculative attack could occur within a day, and the ECB would have to assume all of the marketable securities from countries that suffer the speculative attack. Since the ECB has a relatively small capital base, it would not be able to purchase a large amount of assets from countries that suffer the attack.

There are, after all, many similarities in both situations. Most notable is the fact that both central banks seem to have under-estimated the amount of quality assets (or foreign exchange in the case of the BoE) they needed to hold to defend their monetary policy effectively.

Or, in other words, their ability to corner the markets was compromised because they misjudged the level of stock it would take to influence the markets.